How Recall-Plagued Toyota Lost Its Way

Toyota (TM) has now recalled about 9 million vehicles and counting, including the latest recall involving 8,000 2010 Toyota Tacomas to inspect their front drive-shaft which could contain a cracked part that could get even worse when customers drive the truck. When joined with the sudden acceleration problems and flawed breaking systems of various other Toyota models, it seems likely that Toyota has lost its way. The reason? Toyota abandoned the Toyota Way in its quest for growth. The Toyota Way was a management method in which newly hired Toyota engineers would work closely for 10 years with experienced masters who taught the newbies how to make the trade-offs between the pressure to lower costs and the need to maintain high quality, according to the Washington Post. The Toyota Way enabled Toyota to produce high quality vehicles less expensively and charge a price premium, about which I wrote, since they lasted longer and cost less to maintain.

That strategy contributed heavily to Toyota's growth over many decades because that reputation for top quality attracted more satisfied customers who recommended Toyota to others. But all that changed in the early 2000s. As I posted, in 2002 Toyota saw a chance to overtake General Motors as the world's largest vehicle manufacturer which set Toyota on a too-rapid growth path -- it produced 60% more vehicles in 2008 than in 2000 -- that stressed the Toyota Way to its breaking point.

While all the details have yet to be unearthed, a general picture of what went wrong is emerging. The biggest problem is that as Toyota grew, it was unable to produce enough engineering mentors to train for 10 years the new engineers that it was hiring to design the new models needed to meet its corporate growth targets. The new engineers made bad design choices which lowered cost and quality -- under the Toyota Way, remember, engineers had been able to cut costs while maintaining or boosting quality.

There were other problems as well -- from Toyota's decision-making style to ignoring customer complaints -- that allowed these bad design decisions to persist. For example, although most of Toyota's sales came from North America, all corporate decisions were made in Japan -- where Toyota executives lacked in-depth insights into the conditions in the U.S. market.

And as the Washington Post reported, Toyota's executives outlined specific process problems that contributed to the nine million vehicle recall:

Toyota did not thoroughly test new cars under a variety of road conditions -- instead relying on computer models which missed problems such as Prius brakes not working well on wet road surfaces;

Toyota did not gather customer complaint data from U.S. customers to identify problems and redesign its products and processes; and

Toyota did not share data about sticking gas pedals in European vehicles with managers in the U.S.

So now that all this information is out, does this mean that Toyota stock -- now trading 43% below its December 2006 all-time high of $134 -- is a screaming buy? At a Price/Earnings to Growth (PEG) ratio of 2.1 -- on a forward P/E of 25.2 and average annual earnings growth of 12% for the next five years -- the stock is not cheap.

And since I believe it will take another year for Toyota to find all the problems and discover the underlying causes of all of them, I am not expecting Toyota to be able to redesign its management methods and fix all the problems it discovers for another three to five years.

Until then, its earnings growth forecasts are suspect and I would not be shocked to see more big recalls which could further sink its stock price.